How to Manage Risk: 10 Rules to Keep Your Trading Profitable

Whether you're a budding trader, or you've been doing this a long time; if you haven't learned how to manage your risk, then chances are you've blown out a few trading accounts, or are on the verge of doing so.

Risk management is of the utmost importance for every trader, and should be thought of as the number one reason traders fail at their profession. If you haven't been told, or have simply ignored the advice, I'll lay it out simply for you here:

1. Before you ever place a trade. Know how much risk you have on the table. In other words, how much you stand to lose.

This may seem like a given, but the fact remains that there are many traders who like to fly by the seat of their pants, and focus on how much they stand to make instead of what they could possibly lose if things don't go as planned.

2. Never ever risk more than 1 to 5 percent of your total capital.

This is a hard and fast rule that should be applied no matter what. It is a common trap to allow yourself to risk a lot to gain a lot. This comes with the idea that you're gonna make some quick cash to establish your trading account, and then start following the proper risk allocation once that happens (at least that's what my thinking was like). Well let me tell you, it doesn't happen. If you can't follow proper risk management now, then you won't be able to follow it with more money in your account. If you have a smaller account (less than 75,000) then 5% is okay, but if you're managing above 100,000 then you should risk no more than 1% per trade. You should never feel anxiety or stress over a trade that has hit max loss.

3. Place high probability trades.

This is such a simple statement, but it's another one of those over looked ideas that traders make. Instead of buying OTM options. Try selling them. By simply selling an OTM option you increase your probability of profit enormously. On the other hand, why would you want to purchase anything with less than 50% probability of profit? Not to mention the fact that every day you hold it it decreases in value. It's very closely related to trying to paddle upriver with your hands for paddles. It may work once and a blue moon, but your gonna lose on a consistent basis. If you're gonna buy an option, buy ITM. 

For more ideas on how to make high probability trades you will want to check out this article: 3 UniqueWays to Increase YourProbability of Profit.

4. Don't wait till expiration. Take profits at 50% profitable.

Here is a novel idea that ties in with the last one. Option expiration week can be a crap shoot, and a winning trade can quickly be replaced by a losing one. By placing high probability trades, and taking your profits when you have them, you will not only become consistently profitable, but you will also be seen as one of the smarter guys in the room. Since every trade has a probability of being a loser, and a winner, it's just best to take your winner when it shows up without sticking around. Studies done by TastyTrade have shown that taking profits at 50% provide the biggest edge with the least amount of risk.

5. Place as many trades as possible.

This may seem counter-intuitive, but if you're following rule number 3 you want as many trades placed as possible so that the numbers can fall into place. The more instances you have, the greater the likelihood that the probabilities you trade, will play out. Everyone has winning, and losing streaks. The key is to keep it averaged out so that the losing streaks don't eat into your profit taking.

6. Give yourself enough time to be right.

Since all trades have the chance that it will be both a winner and a loser at some point. You want to make sure that you are giving yourself enough time to be right. This generally means placing your trades from 30 to 60 days out. In the world of weekly options this can seem like a waste of time, but remember, we can successfully manage our risk by giving our trades the greatest chance to succeed, and time gives us an edge that weekly options traders will never have.

7. Use the right strategy for the right environment.

Not all trades are created equal. It is vitally important to keep track of IV Rank (Implied Volatility), and percent change. These two factors can help you gauge whether or not that Iron Condor can best be used instead of a Calendar Spread. Remember, there are a variety of strategies that can be implemented best in certain market environments. Knowing these strategies, and learning how to read the market will give you another edge to keep risk low, and profits up.

8. Don't be afraid to sit in cash.

Sitting in cash waiting for the right set-up can seem like a waste of time when you could be trading. The reality is, that being in cash is a trade, and there are times that it is okay to wait. Being in a rush, and looking for trades that aren't there is a risky endeavor, and has never gotten me closer to my trading goals. You'd be better served to wait for your trade set-ups, or even spend time paper trading (or researching) new ones that will give you more options for more market conditions.

9. Plan your trades, trade your plan.

This is one of those sayings that floats around the trading education scene a lot. It is an extremely important risk management tool though, and you would be hard pressed to overlook it. No business can be successful without a focused plan, and the same holds true for trading, because it is a business. If you don't look at trading as a business, then you need to start doing so. Having a focused and detailed trading plan will provide you with a tool to fall back on in times of stress. Knowing your trading plan, and following through with it will also help you be more consistent, and accountable.

10. Trade with enough capital.

How much capital is enough? Well, it all depends on your trading plan, and what strategies you plan on using. For a small account though, I'd say no less than $10,000. This will give you enough capital to place spread trades that are $5 wide without breaking rule number 1. That means you can implement most strategies and keep your risk down to appropriate levels. More capital is always better though :).

There you have it. Risk management in 10 easy to follow rules. Just don't let your ego/greed get in the way, and it truly is easy. I think I've broken all of these rules at one point or another and have learned the hard way. Greed, impatience, and ego are all things that we traders have to master, and gain control over. Consistently practicing these proper risk management rules will help you overcome your trading pitfalls.

Have you broken these rules? Have a question? Just wanna leave a comment? Have something to add? Feel free to leave something in the comments.